US Vehicle Electrification Will Be a Protracted, Decades-Long Process

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A new study from The Conference Board projects that even if new EV sales rise gradually to 100% by 2040, 40% of all cars and trucks on the road in 2040 might still be powered by fossil fuels.

According to The Future of US Vehicle Electrification and GHG Emissions, businesses must be prepared to manage their operations in a bifurcated and rapidly changing market environment.

In 2022, the share of electric vehicles (EVs) sold in the US hit a record high of nearly 6%.

“EV adoption is set to surge in the coming decade, but new vehicle sales tell only part of the story,” said Alex Heil, Senior Economist at The Conference Board. “Americans are holding on to their cars longer than they once did, with the average age of light vehicles exceeding 12 years in 2022. As a result, the US may need to support both a rapid ramp-up in EV charging and continued operation of fossil fuel infrastructure for decades to come—unless private investment, policy incentives, and consumer demand can spur even faster EV adoption and vehicle replacement.”

EVs are likely to reach 50:50 parity with fossil-fuel vehicles in 2038.

In this scenario, EVs account for 66% of new cars and light trucks and 25% of new medium and heavy trucks by 2032, before reaching 100% of all new vehicles by 2040.
The transition to EVs will create a bifurcated transportation fuel system that persists for at least the next three decades.

Reaching net zero by 2050 will be doubtful without accelerating electrification of the transportation sector: If EV sales reach 100% by 2040, annual greenhouse gas (GHG) emissions from fossil fuel vehicles would fall by 51% based on current performance standards—a dramatic drop, but still far off the US goal of net zero in 2050. Indeed, a sizable portion of GHG emissions would remain in the absence of greater efficiencies for fossil fuel vehicles and potential adoption of alternative fuels like hydrogen for difficult-to-electrify subsectors. Businesses face a transition risk in the decades ahead until near-complete electrification has occurred.

In the interim, investments in fossil fuel infrastructure—including refineries, storage tanks, and fueling stations—would still be necessary, despite the decline of the gasoline and diesel markets in general. The rate of decline will determine the profitability of any such investments, integration of charging and refueling stations, and the willingness of businesses to commit financial resources.
EV Transition Will Require a New Policy Framework for US Infrastructure Funding.

Among the serious complexities of electrification is its impact on the federal Highway Trust Fund (HTF), which has historically funded the maintenance and replacement of US road and transit through gasoline and diesel taxes.

In a supporting brief, EV Adoption Could Exacerbate Transportation Infrastructure Funding Shortfall, The Conference Board finds that fuel tax revenue could fall by 60% assuming EVs reach 100% market share of new vehicles by 2040. This will exacerbate challenges to the HTF—which is already chronically underfunded because gas taxes have not been raised since 1993.

Ultimately, an alternative funding mechanism may be needed to ensure the viability of US transport and supply chains: Businesses might have to prepare to pay for new costs such as fees based on vehicle miles traveled (VMT) or on electricity used for charging.

While HTF revenue is paid today when motorists purchase fuel, a future system may be based on peak demand or specific impacts on infrastructure during use.
This shift to a new system, while not entirely costless in itself, could open up new efficiencies via better route choices or time-of-day planning.
Data security will become a critical issue for businesses and households.

A new system of telematics—data collected from vehicles via sensors or smart devices for pricing and revenue collection—would be needed to implement a more dynamic charging and cost recovery system.

The Rise of Private Equity in Tech M&A

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Private equity firms have been a bright spot in the M&A market this year. Private equity led 57% of public-to-private technology deals in the first half of 2023—almost double their share of public-to-private technology deals in 2020, 2021 and 2022.

To discuss the landscape of opportunities in technology M&A, Morgan Stanley’s Capital Connections Summit brought together top executives from the private equity and venture capital community. Investors gathered in Pebble Beach, California to discuss the M&A outlook for software companies and key themes to watch for the next wave of M&A.

“We brought together the top private equity and venture capital funds in the world, because these two cohorts will inevitably work together on deals—more so than they ever have in the past,” says Umi Mehta, Global Head of Technology Private Equity and Venture Capital Investment Banking, which hosted the Capital Connections Summit. “The intention of the Summit was not only to highlight private equity firms as the most active tech M&A buyers in the near- and medium-term, but venture capital funds as partners that help scale and monetize private equity’s future assets.”

Private Equity’s Evolution to Tech M&A Dominance

Private equity firms have evolved into subject matter experts that offer technology companies operational expertise and the opportunity to invest in sales, marketing, and research and development, according to EB Kapnick, Head of East Coast Technology M&A. They are looking for quality technology companies with the potential for growth, with enduring business models that have large total addressable markets.

“Private equity companies have growing expertise and specialization in software technology, and they are making tech companies more interesting to strategic buyers,” Kapnick says. “With their experience, they can make good companies even better, which makes them a competitive buyer. They’re not just reducing costs but increasing margins, accelerating growth and bringing in new leaders.”

They are also raising larger funds—available capital now stands at a record $2.49 trillion. In this market, private equity firms will often pay comparable or even higher premiums than strategic buyers. Melissa Knox, Global Head of Software Investing Banking, notes that the bid-ask spread between technology buyers and sellers is finally narrowing this year. This is helping to fuel more private equity M&A activity, especially as sellers temper their valuation expectations following peak levels in 2021.

How the Macroeconomic Environment Cooled IPOs

In 2022, higher interest rates, inflation and recession concerns weighed on companies’ profits and share prices in the consumer spending, advertising, and tech industries. In 2022 and 2023, public tech companies felt pressure to do more with less, prioritizing operational efficiencies and cost reductions. However, these efforts can take time and public markets are not always willing to wait, which is why some public tech companies will consider returning to private ownership. Selling their companies to a financial sponsor gives them the opportunity to rebuild without the pressure of delivering returns in a difficult market environment.

Private companies, meanwhile, are now more hesitant to consider IPOs and more open to the possibility of selling. “The bar to go public is much higher in terms of scale and financial profile,” Knox says. “It’s hard to manage employees and financials on a quarterly basis. A lot of private companies will rather merge or be acquired than go through an IPO.”

Private Equity Firms Eye Cloud Companies Amid AI Disruption

The consolidation of cloud-based software firms could also create additional takeover opportunities for private equity companies. Many cloud companies flourished after the boosts to remote work and e-commerce in 2020 and 2021, but more recent innovations in artificial intelligence may obviate some of these businesses, while creating greater demand for others. For example, a cloud-based customer support company might be negatively affected by AI’s potential to disrupt customer relationship management, while companies that provide cloud computing and optimization could benefit from the massive amounts of data and computing power that AI requires. “There will be cloud companies that get disrupted by AI,” Kapnick says. “Not everyone is going to be a winner in this.”

AI may also spur more strategic M&A activity, as companies seek new capabilities, customer segments and buildouts of their own platforms. AI companies are also attracting venture capital, as firms seek opportunities to provide growth-stage money and fund future M&A targets.

“It’s going to be another wild ride in tech in the next few years,” because of the revolutionary “platform shift” of AI, Kapnick says. “Like 1996 before the dotcom wave, or 2017 before the big cloud wave, the amount of spend that moves to technology is going to be unlike anything we’ve ever seen.” In addition to AI’s domino effect, private equity firms are also watching vertical software companies with large total addressable markets in sectors such as healthcare, media and industrials.

Northern Trust Asset Management Names New CIO of Global Asset Allocation

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Captación de capital de Dynasty Financial

Northern Trust Asset Management (NTAM), a leading global investment management firm with $1.1 trillion in assets under management as of June 30, 2023, announced that Anwiti Bahuguna, Ph.D., has been hired as Chief Investment Officer of Global Asset Allocation.

In this newly created role, Bahuguna will oversee NTAM’s entire asset allocation effort. As a member of Northern Trust’s Investment Policy Committee, she will be a key contributor in the development of the firm’s asset allocation recommendations. Bahuguna will report to Northern Trust Asset Management Global Chief Investment Officer Angelo Manioudakis.

“Increasingly, our clients are looking for holistic asset management solutions to their most complex investment challenges,” Manioudakis said. “With the addition of such an accomplished investment professional to our team, I am confident we can continue meeting the evolving needs of investors.”

Bahuguna will now oversee the firm’s asset allocation and multi-manager teams. Bahuguna’s appointment, in conjunction with the appointments of Michael Hunstad to Deputy Chief Investment Officer and CIO of Global Equities and Sheri Hawkins to Head of Investment Platform Services earlier this year, further strengthens NTAM’s investment capabilities.

NTAM’s multi-asset and multi-manager portfolios had $125 billion in assets under management and assets under advisement as of June 30, 2023.

Bahuguna joins NTAM with 25 years of industry experience. Most recently, she was head of U.S. multi-asset strategy at Columbia Threadneedle Investments, where she was responsible for approximately $45 billion in assets under management.

Previously, she served as the lead portfolio manager for the firm’s asset allocation funds and separately managed accounts. She was actively involved in setting the firm’s capital market assumptions, strategic asset allocation, tactical asset allocation, manager selection, and derivative overlays. Bahuguna holds a Ph.D. in economics from Northeastern University and a bachelor’s degree from St. Stephen’s College, University of Delhi.

Why Are so Few Stocks Driving the Market this Year?

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A few mega-cap stocks have driven market returns so far this year. Just ten companies have produced three-quarters of the return of the MSCI United States Index through the first half of 2023. This has led investors — generally those who missed owning these leaders — to complain about narrow “market breadth.” Implicit in this view is that more stocks should be producing positive returns. But is this intuition correct? Is the market’s narrow breadth a signal of trouble to come? Should we expect the softer names to eventually catch up?

We compared the concentration of returns through the first six months of 2023 with the preceding ten years. As shown in the table below, 2023 has been more extreme than normal. This year, 75% of the market’s return was produced by just ten stocks. In most years, the top 10 stocks produce about a third of the market’s return.

But this historical pattern is still highly concentrated. To have 10 stocks — out of hundreds in the index — generating a third of the index return is not a broad market. It is a narrow market. To our mind, this suggests that expecting market “breadth” is generally a misguided assumption.

The table also illustrates the percent of constituents that outperform the index. In almost every year, less than half of stocks outperform the overall index. This year, the ratio is lower than normal at just 30%, another illustration of the higher-than-normal concentration. Importantly, over the entire sample period, the ratio is lower still at just 17%. That the success rate diminishes at longer horizons demonstrates the reduced chance of a stock sustaining outperformance over multiple years.

A large body of empirical work proves this point more rigorously. Academic researchers have analyzed decades of data in both the U.S. and international equity markets. Their work demonstrates that stock returns are very concentrated at long horizons. Hendrik Bessembinder, a finance professor at Arizona State University, found that just 4% of stocks produced all the net dollar wealth creation in US equity markets over the nearly century-long period from 1926 to 2019. The other 96% of stocks, in aggregate, added no value over their respective lifetimes.

Professor Bessembinder titles his article with a provocative question: “Do stocks outperform Treasury bills?” He shows that the answer is no. Four out of every seven stocks have lifetime buy-and-hold returns less than one-month Treasuries over matched timeframes. In other words, the median stock will underperform a risk-free bill over its life.

This contradicts our intuition about equities. How can the stock market deliver attractive returns, even if most stocks are duds? The answer is that market averages are driven by a small number of exceptional performers. Over time, these big winners grow into larger index weights and become the primary drivers of returns, while the losers shrink into irrelevance. In equity investing, you should not expect the average stock to deliver the average result.

Stock markets follow a power law. In a power law distribution, the average result is pulled higher by a few positive outliers, while most results are far below average. This is distinct from the classic “bell curve” normal distribution that characterizes most randomly distributed variables. The charts below illustrate these two distribution functions.

For example, the height of American adult males is normally distributed around a mean of 5’9”. In a normal distribution, the median observation will be equivalent to the mean (or average). If you took a group of 100 men, arranged them in order of height, and then pulled out the man in the 50th position, he would probably be 5’9” tall. The median and the mean are the same.

This does not hold true for stocks, particularly over longer horizons. Let’s return to the MSCI United States Index to see if it exhibits a power law distribution. Over the ten and half years of our analysis, the index delivered a total return of 13.5% annualized, or 278% cumulatively1. That’s the market average. There were 1,004 distinct stocks in the index over the period. The best was Nvidia Corp, which returned nearly 15,000% cumulatively. On the other side, there were several stocks roughly tied for worst that lost around 90% of their value, including First Republic Bank, Affirm Holdings, and SunEdison Inc. The median stock, or the one right in the middle of the list, was Eastman Chemical Co., which returned 62% cumulatively, or about 5% per year. As we should expect from a power law distribution, the median is not representative of the average result, but rather significantly worse than average. The average was pulled up by a very small number of positive outliers.

At Thornburg, we hunt for these outliers. Our portfolio managers and analysts search globally for exceptional companies that have the potential produce these positive results. This may come in the form of powerful growth that exceeds market expectations, or more consistent growth that compounds over time. Both types of companies populate the lists of top performing stocks. As active investors, we assemble concentrated portfolios of stocks with these characteristics, and aim to hold them for the long term to allow compounding to work.

While commentators are correct to observe that this year’s market is narrower than normal, market breadth is a myth. A few stocks drive most returns over time. Power laws are the rule, not the exception. It’s not just academics who have figured this out. As Warren Buffett acknowledged in his most recent letter to Berkshire Hathaway shareholders: “The lesson for investors: The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders.”

Opinion piece by Nicholas Anderson, CFA, Portfolio Manager and Managing Director in Thornburg Investment Management.

Citi Aligns Organizational Structure With Its Strategy and Simplifies Operating Model

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Citi announced significant changes to its organizational model that will fully align its management structure with its business strategy and simplify the bank. The new, flatter structure elevates the leaders of Citi’s five businesses and eliminates management layers, which will speed up decision making, drive increased accountability and strengthen the focus on clients. Simplifying the organization will also advance the execution of Citi’s Transformation, the firm’s top priority.

“I am determined that our bank will deliver to our full potential, and we’re making bold decisions to meet our commitments to all our stakeholders,” said Citi CEO Jane Fraser. “These changes eliminate unnecessary complexity across the bank, increase accountability for delivering excellent client service and strengthen our ability to benefit from the natural linkages that exist amongst our businesses, all with an eye toward delivering on our medium-term targets and our Transformation.”

Streamlined Leadership

The leadership of each of Citi’s five interconnected businesses will now report directly to CEO Jane Fraser and become members of the Executive Management Team. This move ensures that business leaders have greater influence on Citi’s strategy and execution while enhancing accountability. Investors will also benefit from increased transparency into the bank’s core operations. The five business leaders responsible for driving Citi’s success are:

  • Shahmir Khaliq, Services
  • Andrew Morton, Markets
  • Peter Babej, Banking2 (interim)
  • Andy Sieg, Wealth (effective September 27)
  • Gonzalo Luchetti, U.S. Personal Banking

Consolidation of Geographic Leadership

The bank has consolidated leadership for its geographies outside of North America under the guidance of Ernesto Torres Cantú, Head of International. This restructuring narrows the scope of Citi’s geographic management to focus on local-market client coverage, delivery, and legal entity management. By sharing a common management team, Banking and International will foster greater connectivity across Citi, benefiting clients under a leaner structure.

Client-Centric Focus

Recognizing the importance of strengthening client engagement and experience, Citi has introduced a new Client organization. This team, led by David Livingstone, will be responsible for enhancing client engagement across the bank’s global network and businesses, reinforcing Citi’s commitment to providing top-notch client service.

Citi’s Strategic Evolution

These organizational changes come as the next logical step in Citi’s journey to implement its strategic plan, which was unveiled at its 2022 Investor Day. Over the past three years, the bank has diligently worked to be the premier banking partner for institutions with cross-border needs, a global leader in wealth management, and a trusted personal bank in its home market.

Citi’s relentless focus on its five interconnected businesses, swift progress in exiting consumer franchises outside the United States, and ongoing efforts to bolster risk management and controls demonstrate the bank’s determination to deliver on its medium-term targets and its transformation agenda.

Citi’s CEO Jane Fraser emphasized the significance of these changes in driving the bank’s success. “I am determined that our bank will deliver to our full potential,” she declared. “These changes represent our unwavering commitment to excellence and to meeting the evolving needs of our clients.”

The new organizational structure, with its emphasis on agility, accountability, and client-centricity, positions Citi to continue its transformation journey and provide exceptional service to clients worldwide.

Effective immediately, the new Executive Management Team includes:

Jane Fraser – Chief Executive Officer

Peter Babej – Interim Head of Banking; Chairman of Banking

Titi Cole – Head of Legacy Franchises

Nadir Darrah – Chief Auditor

Sunil Garg – CEO of Citibank, N.A. and Head of North America

Shahmir Khaliq – Head of Services

David Livingstone – Chief Client Officer

Gonzalo Luchetti – Head of U.S. Personal Banking

Mark Mason – Chief Financial Officer

Brent McIntosh – Chief Legal Officer and Corporate Secretary

Andrew Morton – Head of Markets

Anand Selvakesari – Chief Operating Officer

Andy Sieg – Head of Wealth (beginning September 27)

Edward Skyler – Head of Enterprise Services & Public Affairs

Ernesto Torres Cantú – Head of International

Zdenek Turek – Chief Risk Officer

Sara Wechter – Chief Human Resources Officer

Mike Whitaker – Head of Operations & Technology

Paco Ybarra – Senior Advisor

Alternatives Managers Are Missing the Self-Directed Investor

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Alternatives managers are exceptionally focused on gathering capital from retail advisors yet are missing an important and underserved client group—self-directed investors. According to The Cerulli Report—U.S. Alternative Investments 2023, there is opportunity for asset managers that have the necessary scale in place to reach these self-directed investors.

Overall, alternatives managers rank direct-to-investor initiatives as less important than others—58% report that reaching non-high-net-worth (HNW) investors directly is not an initiative for their firm, and 27% say the same for reaching HNW investors directly.

Currently, retail distribution of alternative investments is focused on sales via financial advisors, and especially those with wealthier clients.

Yet, direct platforms have amassed considerable investor assets and will control an estimated $21 trillion in 2028, up from approximately $11 trillion in 2022. “Asset managers with direct platforms have a built-in reach to direct-end investors. The platforms are already trusted by investors and not likely to incur steep customer acquisition costs,” states Daniil Shapiro, director. In addition, such platforms already have the clients—and a vault of information—for providing some exposure to alternative allocations.

A logical next step for such platforms is to leverage their scale with the provision of intermittent liquidity products. Interval funds, for example, are one step beyond the mutual funds that are already available for purchase on such platforms. Cerulli recommends that firms that already provide broad market exposures to direct end-investors evaluate whether or not they can expand access to less than fully liquid alternative investment offerings to existing investors.

“While offering self-directed investors access to alternative investments is a significant lift, the firms that already have such relationships should consider it, carefully evaluating the risks and costs (e.g., incrementally more burdensome subscription processes, helping investors navigate a lack of liquidity) against the benefits, which include their securing more attractive fees and helping their investors,” says Shapiro. “Their competitive advantage in offering such access can make it worthwhile and help individual investors avoid riskier exposures elsewhere,” he concludes.

Global Ultra Wealthy Population Shrinks for the First Time Since 2018

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Altrata, the global data-driven intelligence on the wealthy and influential, released the 11th edition of the World Ultra Wealth Report 2023. The report reveals a 5.4% decline in the ultra high net worth (UHNW) population in 2022, the first annual decrease of this population in four years and the most substantial contraction since 2015.

The World Ultra Wealth Report 2023 leverages Wealth-X data and sheds light on the state of the global UHNW population; those with a net worth of $30 million or more. Despite the annual decline in population, the ultra wealthy still hold more than $45 trillion in assets, with median wealth of $51 million per person.

Leveraging Wealth-X’s proprietary Wealth and Investible Assets Model, the global ultra wealthy population is expected to total 528,100 people by 2027, an increase of 133,000 on 2022 levels. UHNW wealth is projected to rise to $60.3trn, implying an additional $14.9trn of newly created wealth over the next five years.

The recent decline impacted global regions and cities differently. Among the numerous findings, the World Ultra Wealth Report 2023 reveals that North America remains the leading ultra wealth region by far but saw a 4% decline in population in 2022; this was the biggest annual fall in a decade.

However, Asia experienced the largest fall of any region with a 10.9% decrease in ultra wealthy individuals and a 10.6% decrease in their overall wealth.

Europe’s wealth assets were hit hard by an inflationary spike and energy crises stemming from the Russia-Ukraine war, and the region experienced a 7.1% decline in its ultra-wealthy population, while the Middle East, Latin America and the Caribbean saw strong gains in ultra-wealthy individuals and total net worth.

The report goes on to examine different ultra wealthy archetypes, namely entrepreneurs, corporate executives, and sole inheritors. These archetypes highlight the similarities and differences among these demographics by wealth source, asset allocation, industry affiliation, luxury asset ownership trends and more.

“Whether by chance or design, the turbulent backdrop of 2022 provided wealth-creation opportunities for some among the ultra wealthy class,” said Manuel Bianchi, head of global sales for Altrata.

SEC Charges Five Advisory Firms for Custody Rule Violations

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The Securities and Exchange Commission announced charges against five investment advisers for failing to comply with requirements related to the safekeeping of client assets.

Three of the firms were also charged with failing to timely update SEC disclosures regarding audits of their private fund clients’ financial statements. All five advisory firms have agreed to settle the SEC’s charges and to pay more than $500,000 in combined penalties.

The advisory firms are Lloyd George Management (HK) Limited; Bluestone Capital Management LLC; The Eideard Group, LLC; Disruptive Technology Advisers LLC and Apex Financial Advisors Inc.

According to the SEC’s orders, the five firms failed to do one or more of the following: have audits performed; deliver audited financials to investors in a timely manner; and/or ensure a qualified custodian maintained client assets. In addition, according to the SEC’s orders, two of the firms failed to promptly file amended Forms ADV to reflect they had received audited financial statements, and one of the firms did not properly describe the status of its financial statement audits for multiple years when filing its Form ADV.

“The Custody Rule and the associated Form ADV reporting obligations are core to investor protection,” said Andrew Dean, Co-Chief of the SEC Enforcement Division’s Asset Management Unit. “We will continue to ensure that private fund advisers meet their obligations to secure client assets.”

Without admitting or denying the findings, the firms agreed to be censured, to cease and desist from violating the respective charged provisions, and to pay civil penalties ranging from $50,000 to $225,000.

This is the second set of cases that the Commission has brought as part of a targeted sweep concerning violations of the Investment Advisers Act’s Custody Rule and Form ADV requirements by private fund advisers after charging nine advisory firms in September 2022.

Home Prices Tick Up After Two Months of Declines

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Following two months of year-over-year declines, home prices rose in August (+0.7%) as the number of homes on the market decreased for the second month in a row, down -7.9% year-over-year, according to the Realtor.com® August Monthly Housing Trends Report.

Active inventory remained -47.8% below typical 2017 to 2019 levels, although an unseasonable increase in newly listed homes from July to August (+3.5%) this year provides more options for home shoppers as the fall buying season approaches.

“While the uptick in new listings is good news for home shoppers, inventory remains persistently low, even with record-high mortgage rates putting a damper on demand,” said Danielle Hale, Chief Economist for Realtor.com®. “The inventory crunch continues to put upward pressure on home prices, amplifying affordability concerns and shutting some potential buyers out of the market. However, we anticipate mortgage rates will gradually ease through the end of the year and, despite this month’s bump in home prices, we’ll be unlikely to see a new price peak this year.”

What it means for homebuyers, sellers, and the housing market
Although home sellers were less active in August compared to last year, the increase in newly listed homes for sale from July to August creates a nice boost for shoppers heading into fall, which is typically the best time to buy a home. Homeowners who have been on the fence about selling will likely find eager buyers looking for fresh listings.

“As fall buying activity heats up, the newly available homes for sale aren’t likely to remain on the market long, so sellers and hopeful homebuyers will need to be prepared to move quickly,” said Realtor.com® Executive News Editor Clare Trapasso. “Home shoppers can save searches on Realtor.com® to receive real-time alerts, receive mortgage pre-approvals, and pore over their budgets to determine what they can realistically afford with today’s higher mortgage rates.”

Affordability remains a significant concern. Although sales of new homes are on the rise, construction activity isn’t sufficiently robust to offset the inventory shortage and ease prices, which are up nearly 38% from August 2019 levels. Additionally, elevated mortgage rates have raised the monthly financing cost of the average home by about $417, up 21.7% from August 2022. This greatly exceeds both wage growth (4.4%) and inflation (3.2%).

Newly listed homes improve from July, but inventory crunch continues
While the market saw an unusual bump in newly listed homes for sale between July and August this year, the overall number of homes actively for sale shrank for the second consecutive month, reversing the consistent growth trajectory seen since April 2022. Some of this drop can be attributed to an off-season surge in inventory during a market slowdown last summer. Although active inventory still remains below typical pre-pandemic levels seen between 2017 and 2019, the modest rise in new homes listed for sale this summer could give buyers grappling with affordability issues more options.

As inventory shrinks, homes in several large markets sell faster compared to last year
The time homes spend on the market is approaching last year’s quicker figures, with buyers again vying for fewer available options than the prior year in most parts of the country. Should this pattern continue, by the coming month homes in every region except the South are likely to sell faster than they did during the same period last year.

High Yield Bond 2023 Mid-Year Outlook

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Pixabay CC0 Public Domain

The US high yield market delivered strong returns in the first half of 2023, with the ICE BofA US High Yield Constrained Index gaining 5.42%.  Solid economic data to start the year helped credit spreads tighten in the initial weeks of 2023.  However, a round of bank failures including Silicon Valley and First Republic triggered a flight to quality later in 1Q23.

After the market digested another manufactured debt ceiling crisis in the US, signs of deflation and improving odds of a “softish” landing for the economy drove a vigorous rally in risk assets to end the first six months.  Continued year-over-year growth of high yield issuers’ operating earnings in the first quarter and supportive market technicals also helped to lift high yield bond prices.

While high yield has delivered robust performance thus far in 2023, yields remain close to 8.5%, and Nomura maintains a constructive outlook for the asset class in the second half of the year.  Key drivers of our favorable perspective include:

An Attractive Entry Point

Looking back on 30 years of data, when investors have put money to work with market yields between 8-9%, the median 12-month forward return for high yield was better than 11%.  Similarly, the end of a tightening cycle has been an excellent time to deploy capital to risk assets, including high yield bonds.  There have been five tightening cycles in the US over the last 30-years.  High yield’s average 12-month forward return from the date of the last rate increase was over 12%.  The Fed will likely hike one more time in July, but the end of the tightening cycle is rapidly approaching.

Solid Fundamentals

While it is too early to gauge second quarter results, operating earnings continued to grow in 1Q23, and more high yield issuers have guided 2023 earnings higher vs. those who revised expectations lower.  High yield companies continue to generate cash flow, and they are using those resources to prepare for a slower economy.  Leverage is close to a decade low.  Interest coverage, arguably the best harbinger of the future default rate, is holding above 5x, the first instance in over 30 years of historical data that coverage has breached that threshold.  BB-rated bonds currently represent close to 50% of the high yield market, while CCCs weigh in at just above 10%.  Given the market’s healthy cash flows and higher quality tilt, Nomura expects the default rate to increase but not spike as the economy slows, rising from 1.6% over the last 12 months to a peak near the 3.2% long term average default rate.

Supportive Technicals

In 2022 the US high yield market contracted by roughly $200bil, a sizeable reduction relative to total market cap of close to $1.5tril.  In the first half of 2023, the market saw more than $70bil of calls, tenders and maturities, and nearly $65bil of net rising star upgrades out of high yield.  New issuance totaled about $95bil, thus the market contracted by approximately $40bil in 1H23, bolstering the supply/demand dynamic that drives prices.  We expect the market to continue contracting over the balance of 2023, as a greater volume of high yield bonds are rising star candidates relative to investment grade issues that could drop to high yield.  With less than $75bil of high yield bonds maturing before the end of 2024, we expect issuance to remain relatively light.

Flows Improving

According to Lipper data, high yield mutual funds and ETFs saw net outflows in excess of -$10bil in the first half of 2023.  June net flows were positive $2.5bil, as investors perceived a favorable opportunity to add exposure to high yield.  Nomura has experienced a comparable flow pattern in 2023.  Net flows were relatively flat in the first five months of the year, masking a host of large subscriptions and redemptions, before flows turned meaningfully positive in June.  Clients added to high yield for a variety of reasons including a more favorable tactical outlook for the asset class and portfolio rebalancing back to fixed income as a result of the heady equity returns in 1H23.

Favorable Outlook vs. Investment Grade

Based on our conversations with clients and prospects around the world, we believe that many investors have parked cash on the sidelines, enjoying T-bill yields approaching 5.5% while accepting reinvestment risk.  A moderating growth and inflation outlook could prompt investors to re-risk portfolios by adding credit and duration exposure.  When faced with the option of transitioning fixed income allocations into investment grade or high yield credit, we expect more clients to opt for the latter.  Due to the steep inversion of the US Treasury yield curve, investors moving from 6-month T-bills to investment grade corporates (as proxied by the ICE BofA US Corporate Index – C0A0), picked up only 13bps of additional yield as of June 30.  Investors would increase yield by more than 300bps moving from 6-month T-bills to the ICE BofA US High Yield Constrained Index (HUC0).

As of June 30, high yield (HUC0) offers a yield to worst of 8.6% with a duration less than 4 years.  Investment grade (C0A0) yields 5.6% with a duration of 6.9 years.  In a sideways market, high yield’s carry will likely help the asset class outperform.  In a rising rate environment, shorter duration will advantage high yield relative to investment grade.  High yield’s credit spread close to 400bps is not excessively cheap, but there is room for spread tightening if the US manages to avoid recession and land softly.  Investment grade would likely outperform in a harsher than expected recession.  However, we view that scenario as unlikely given the strong economic growth ongoing in sectors like travel & leisure, energy, and infrastructure, and the continuing imbalance between labor demand and supply supporting today’s robust job market.

Given these tailwinds, Nomura believes the current environment offers investors a favorable opportunity to increase portfolio allocations to high yield bonds.